The CFC consultation. - The latest step on the road to reform. Application of the Regime

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Nigel Jacobs
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The CFC consultation - The latest step on the road to reform After some four years since the process for the reform of the controlled foreign company ( CFC ) rules commenced, the Government finally

1 The CFC consultation - The latest step on the road to reform After some four years since the process for the reform of the controlled foreign company ( CFC ) rules commenced, the Government finally published on 30 June 2011 the Stage 2 consultation document which details how the CFC regime is to operate in future. The fundamental premise behind the reforms is to move to a more territorial tax system for the taxation of foreign profits, focussing on taxing profits economically derived from UK activity rather than from worldwide business. The full reforms continue to focus on areas where the perceived scope for diversion of profits from the UK is greatest, being CFCs holding IP assets and monetary assets. The new regime will retain many features of the existing regime, applying to UK companies holding at least a 25% interest in a CFC, irrespective of whether the CFC is located in the EU or elsewhere. It will apply to a CFC that is subject to a lower level of tax on its taxable profits but capital gains of the CFC will continue to be outside the scope of the rules. Whilst some of the existing exemptions are essentially retained, there are new territorial business exemptions and a general purpose exemption which will replace the existing motive test. Although there remain a number of areas where further clarification is needed, the proposals represent an improvement on the existing regime and should provide greater certainty as to the application of the rules. Even where a UK company does not qualify for exemption from the rules, it is expected that, save in certain perceived high risk areas, the rules will reduce CFC charges as they will only apply to that proportion of profits treated as artificially diverted from the UK and should only operate to bring into charge up to one quarter of the finance income arising to a CFC at standard corporate tax rates. There are also specific exemptions related to insurance and banking business and the consultation outlines the intended alignment of the tax treatment of exempt foreign branches and foreign subsidiaries by applying the CFC rules to exempt foreign branches. However, the Government is not proposing to extend the finance company rules to branches of UK companies at this time. The consultation also proposes to enable transparent entities, such as US limited liability companies, which are used for genuine commercial reasons, to qualify for various exemptions from the CFC rules. The consultation period will run to 22 September The aim is to publish draft legislation in the Autumn with legislation enacted in Finance Act The Government considers that the new rules are likely to apply for accounting periods beginning on or after the date of Royal Assent to the Finance Bill Application of the Regime The new CFC regime is intended to operate as a three step process, unless the CFC is able to benefit from one of the exemptions: Step 1: Involves identifying a CFC, being a company under UK control, resident outside the UK and whose taxable profits are actually taxed at a lower effective rate than if the CFC were resident in the UK. The lower level of tax threshold will remain at 75% of the UK corporation tax rate at the relevant time. The Government wishes to consult on the definition of control for these purposes. Step 2: Exempts, by applying one of the exemptions set out below, those CFCs that pose a low risk to the UK tax base, being CFCs undertaking genuine commercial activities that do not artificially divert profits from the UK. Step 3: Calculate a CFC charge where profits have been artificially diverted from the UK and determine available reliefs. The charge is intended to be proportional to the UK profits that have been artificially diverted. A UK chargeable profits computation will be required and any UK tax charge will be treated in the same manner as UK corporation tax. Click to jump to: Exemptions CFC with Finance Income CFC with Intellectual Property Income

2 Back to contents Exemptions The exemptions that are intended to be available under the new regime are: The low profits exemption This exemption applies (subject to antifragmentation rules) to those CFCs making a low level of accounting profit determined by applying either (i) a threshold for each CFC of 500,000 (with a limit on investment income); or (ii) an increased threshold in line with the group s size (so that larger groups benefit from higher thresholds, for instance, based on a percentage of total group turnover); or (iii) by retaining the current 200,000 limit introduced as part of the interim reforms. The excluded countries exemption The excluded countries exemption could potentially apply to CFCs in territories in either the first two (or potentially all) of the following three broad categories: a small number of territories with regimes sufficiently similar in terms of base and tax rate to the UK that the CFC can be exempted without further conditions; territories with generally acceptable corporate tax regimes where CFCs could be exempt subject to (a) some general conditions limiting the CFC s total income which is derived from transactions with the UK, investment income (such as finance and royalty income) and lower tax branch income; and (b) a targeted anti-avoidance rule; territories for which specific conditions would be required potentially in addition to the general conditions referred to in the second category above. The specific conditions would consider specific tax breaks including tax holidays and other incentives. A temporary period exemption As is the case under the interim reforms, an exemption would be available for up to 3 years where an overseas subsidiary comes within the scope of the CFC regime as a consequence of a third party acquisition or a reorganisation. The exemption will also contain anti-avoidance provisions. Territorial business exemptions A territorial business exemption would apply to a CFC with a genuine overseas trading operation and foreign profits derived therefrom, including incidental finance income arising from the working capital needs of the business. Three territorial business exemptions are anticipated and a CFC which meets one of these exemptions would be exempt from the CFC rules provided that the CFC is controlled and managed by sufficient staff having the necessary expertise in the territory of the CFC. The exemptions proposed are: Exemption 1 would apply to a CFC which makes a low level of profits (a profits rate safe harbour ) by reference to its cost base and no more than small amounts of investment income. The Government is considering a profits rate safe harbour of 10% of operating expenses (other than the cost of goods acquired for resale and related party business expenditure). Exemption 2 would apply to a CFC carrying on a manufacturing trade which is not involved, to any substantial degree, in activities other than manufacturing. Incidental amounts of investment income including finance and royalty income would be permitted. The exemption would also apply to manufacturing companies using IP which is licensed to the CFC but which is necessary for the CFC to carry out its manufacturing activities; and Exemption 3 would apply to a CFC carrying on commercial activities where there is a low risk of artificial diversion of profits and where the CFC is not engaged, to a substantial extent (ie. more than around 20%), in certain investment activities (such as holding and managing shares and securities other than in companies in the same group and certain types of leasing). This exemption can apply to trading and certain business activities between a CFC and UK persons (whether connected or not) where there is no arrangement in place to artificially divert profits from the UK.

3 The Government is consulting on the introduction of a targeted anti-avoidance rule where the CFC is engaged in activities involving the provision of goods or services directly or indirectly to the UK and where the costs of the activity are incurred in the UK. It is also considering an additional or alternative principles based approach where a CFC would not be exempt if its profits arose wholly or partly from arrangements where there has been a separation of risk and/or where intangibles originate from the UK. It is envisaged that the exemption would also apply to: CFCs generating income from property investment business, comprising income from long term rental of properties outside the UK (where the CFC has the risks and rewards of ownership, there is sufficient local management and, possibly a requirement that the property leased is situated in the same territory as the CFC); CFC s operating high value operating leasing business; local holding companies which hold only trading companies and which receive almost all of their income from within their territory of residence; and holding companies holding only shares in group companies where the dividends such holding company receives would be exempt from UK tax if received in the UK. General Purpose Exemption A general purpose exemption will consider the facts and circumstances of the CFC and will replace the motive test. Guidance is to be published in relation to this exemption. In the absence of transitional rules, CFCs currently exempt under the motive test would need to qualify under one of the new exemptions. This exemption will be relied upon where other exemptions are not available but there will be no default assumption that profits would have arisen in the UK. In order to qualify for exemption, the CFC must be established in its territory of residence with sufficient local management. This exemption would operate to exempt the CFC s profits to the extent that they are commensurate with the CFC s own activities and have not been diverted from the UK for tax purposes. Such profits are those that would, more likely than not, accrue to the CFC if the CFC was an independent entity and not a member of a group. It is suggested that the OECD Model Tax Treaty principles, for attributing profits to permanent establishments, should apply to determine the amount of profit that would arise to the CFC in these circumstances. Profits would also be exempt to the extent that they are not diverted from a connected company in which they would otherwise have been subject to UK tax. Where the assets or risks owned by the CFC would be owned by non-uk members of a group if the CFC was independent and the CFC has only incidental investment income, then all the profits of the CFC should be exempt. In complex situations where businesses want certainty on this exemption, an advance clearance will be available from HMRC. The consultation document includes some examples of how this exemption is intended to apply where a CFC provides intra-group services, undertakes extended warranties business through a captive insurance company or where a UK company transfers IP to the CFC. CFCs with Finance Income The Government is proposing to introduce a finance company partial exemption ( FCPE ) as a pragmatic and competitive approach to dealing with the perceived high risk area of mobile finance income (unless that finance income is incidental and arising from the working capital of the business). The FCPE will apply to a CFC, which is established and locally managed in its territory of residence, to provide a partial exemption for profits arising to a CFC from finance income derived from the CFC lending to overseas group companies and structural surplus cash reinvested within a group. The chargeable finance income would need to be calculated and it is assumed that a debt:equity ratio of 1:3 would apply to the overseas financing company. Where the finance company is debt funded within these parameters, no apportionment would be expected to arise. Where the finance company is wholly equity funded, a partial Back to contents

4 Back to contents exemption is applied which gives rise to an effective 5.75% UK corporation tax rate on overseas intra-group finance income by Credit for foreign taxes paid on that finance income would be proportionately reduced. Consideration is also given in the consultation to options for dealing with complex finance structures of multinationals, where financing is provided between multiple CFCs, in order to avoid the same finance income being subject to more than one UK tax charge. The FCPE will not apply where finance income arises to the CFC from upstream loans to UK group entities, although the Government is considering a different treatment where there are bank restrictions or legal obstacles preventing a dividend payment by the CFC. The FCPE exemption will also not apply where the finance income is earned from moneys held on deposit with third parties. Targeted anti-avoidance rules will be included to address artificial arrangements attempting to overcome these exclusions from the FCPE. It is noted that large amounts of finance income will not be able to be exempted from the CFC charges by sheltering it within trading entities and swamping the CFC with trading profits. Nevertheless, the Government is considering options to deal with companies which undertake mixed activities (including trading and finance activities), including the possibility that intragroup finance income arising in these mixed companies would still be able to benefit from the FCPE. The Government aims to exempt pure group treasury companies under the general purpose exemption. The Government is also considering whether there is a case for exempting finance income where a group makes the substantial majority of its genuine commercial profits overseas which are reinvested overseas and the UK members of the group have no net borrowing costs or where a CFC is funded in a particular way such as a rights issue. CFCs with Intellectual Property Income The aim of the rules regarding CFCs with IP income is to address situations where IP has been developed in the UK and is transferred to a low tax jurisdiction or where IP is located in a low tax jurisdiction but significant amounts of activity to maintain and/or generate the value of that IP are undertaken in the UK. It is expected that the territorial business exemptions and the general purpose exemption will be relevant to CFCs holding IP. The territorial business exemptions are expected to be available to exempt CFCs that have: IP income related to the holding and exploitation of foreign IP which has not been transferred from the UK and has no significant economic connection with the UK; local IP that is integral to a genuine overseas manufacturing trade; and IP royalty income that is incidental or ancillary to the CFC s trade. The general purpose exemption is expected to be used for more complex cases involving: IP which has been developed in the UK but is transferred from the UK to a low tax jurisdiction within the last 6 years (or longer if there has been a CFC apportionment within the last 2 years). A transfer includes the granting of a licence (but not sub-licence which is restricted to the CFC s territory). The Government has set out the factors that it would consider in determining whether the transfer has resulted in an artificial diversion of UK profits and recognises that where related activity and management migrates to the CFC over time, there could be a reduction in the percentage of the CFC profits to which a CFC charge is applied; or

IP which is actively managed or developed in or from the UK, comprising situations where the CFC exploits IP and more than 50% of the CFC s business expenditure relating to the IP is with UK related

The consultation considers the interaction between the CFC rules and both the transfer pricing and capital gains tax rules where double taxation could arise.

5 IP which is actively managed or developed in or from the UK, comprising situations where the CFC exploits IP and more than 50% of the CFC s business expenditure relating to the IP is with UK related parties or more than 20% of the CFC s gross income from the IP is from the UK; and an equity funded CFC which invests in IP that is held offshore as an investment (referred to as an IP money box). The consultation considers the interaction between the CFC rules and both the transfer pricing and capital gains tax rules where double taxation could arise. The Government is considering possibly allowing a credit for corporation tax paid on a disposal of IP to a CFC against subsequent CFC charges arising in respect of that IP or exempting a UK company from the tax charge arising on its disposal of IP to a CFC where the company would be subject to a CFC charge on the profits from the IP. Illustrative examples of the application of the rules are contained in the Consultation Paper. Back to contents Key Contacts Nikol Davies +44 (0) n.davies@taylorwessing.com Michelle Williamson Professional Support Lawyer +44 (0) m.williamson@taylorwessing.com Other Contacts Peter Jackson +44 (0) p.jackson@taylorwessing.com Robert Young +44 (0) r.young@taylorwessing.com Berlin Brussels Cambridge Dubai Düsseldorf Frankfurt Hamburg London Munich Paris Beijing Ω Shanghai Ω Warsaw Δ Taylor Wessing 2011 This publication is intended for general public guidance and to highlight issues. It is not intended to apply to specific circumstances or to constitute legal advice. Taylor Wessing s international offices operate as one firm but are established as distinct legal entities. For further information about our offices and the regulatory regimes that apply to them, please refer to: Ω Representative offices Δ Associated office NB_000598_07.11

Analysis of New Law UK CORPORATE TAX REFORM. Nikol Davies *

70 Analysis of New Law UK CORPORATE TAX REFORM Nikol Davies * INTRODUCTION The long anticipated consultation document for corporate tax reform was published by the government on 29 November 2010. The document